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IRS Issues Partnership Anti-Abuse Rule Regs.

The IRS and Treasury issued final regulations on June 8
to provide that the Sec. 704(c) anti-abuse rule takes into
account the tax liabilities of both partners and certain
owners of partners (T.D. 9485). The regulations also
provide that partnerships cannot use an allocation method
to achieve tax results that are inconsistent with the
intent of the partnership rules in the Internal Revenue
Code.

The final regulations adopt without any changes
proposed regulations that were issued in 2008
(REG-100798-06). (For more on the proposed regulations,
see Tax Trends, “IRS
Issues New Rules on Allocation of Partnership
Items,” 39 The Tax
Adviser 540 (August 2008).) The regulations respond
to a recommendation by the Joint Committee on Taxation in
the wake of the Enron scandal that the anti-abuse rule of
Regs. Sec. 1.704-3(a)(10) be strengthened with respect to
“partnership allocations for property contributed to a
partnership, especially in the case of partners that are
members of the same consolidated group, to ensure that the
allocation rules are not used to obtain unwarranted tax
benefits” (Joint Committee on Taxation, Report of Investigation of
Enron Corporation and Related Entities Regarding Federal
Tax and Compensation Issues, and Policy
Recommendations (JCS-3-03) (February 2003), p.
29).

Under the anti-abuse rule, a method (or combination of
methods) for allocating contributed partnership property
is not reasonable if the contribution of property and the
corresponding allocation of tax items with respect to the
property are made with a view to shifting the tax
consequences of built-in gain or loss among the partners
in a way that substantially reduces the present value of
the partners’ aggregate tax liability. According to the
IRS, a substantial reduction in the present value of an
indirect partner’s tax liability must be considered when
analyzing the reasonableness of an allocation method
because allowing a partnership to adopt a method under
which the tax advantages accrue to an indirect partner
rather than a direct partner would be inconsistent with
the purposes of Sec. 704(c).

Therefore, the
regulations amend Regs. Sec. 1.704-3(a)(10) to provide
that, for purposes of applying the anti-abuse rule, the
tax effect of an allocation method (or combination of
methods) on both direct and indirect partners is
considered. An indirect partner is defined as any direct
or indirect owner of a partnership, S corporation, or
controlled foreign corporation (CFC), or a direct or
indirect beneficiary of a trust or estate that is a
partner in the partnership, and any consolidated group of
which the partner in the partnership is a member.

The regulations also provide that the principles of
Sec. 704(c), together with the allocation methods
described in Regs. Secs. 1.704-3(b), (c), and (d), apply
only to contributions that are otherwise respected. Thus,
even though a transaction may satisfy the literal language
of Sec. 704(c) and the regulations, the IRS may recast the
transaction to avoid tax results that are inconsistent
with the intent of subchapter K. The regulations state
that one factor that may be relevant in determining
whether a contribution of property should be recast is the
use of the remedial method, in which allocations of
remedial items of income, gain, loss, or deduction are
made to one partner and allocations of offsetting remedial
items are made to a related partner.

During the
comment period, the IRS received requests that the final
regulations contain specific examples describing the types
of transactions to which the regulations apply as well as
specific examples of types of transactions that would not
be abusive under these regulations but would be abusive
under the general partnership anti-abuse rules of Regs.
Sec. 1.701-2. The IRS declined to provide such examples
due to the “factually intensive analysis needed to
determine whether this regulation is applicable” (Preamble
to T.D. 9485, p. 2).

The IRS declined to adopt a
de minimis rule
to exclude partners who own less than 10% of the capital
and profits of a partnership or who are allocated less
than 10% of each partnership item. They also declined to
adopt a rule that owners would have to be related to the
lookthrough entity (within the meaning of Sec. 267 or Sec.
707) in order to be considered indirect partners for
purposes of the regulations.

However, the final
regulations did adopt the proposed regulations’ rule that
an owner of a CFC is treated as an indirect partner only
with respect to the allocation of items that (1) enter
into the computation of a U.S. shareholder’s inclusion
under Sec. 951(a) with respect to the CFC, (2) enter into
any person’s income attributable to a U.S. shareholder’s
inclusion under Sec. 951(a) with respect to the CFC, or
(3) would enter into the computations described in (1) or
(2) if such items were allocated to the CFC.

The
regulations are effective for tax years that begin after
June 9, 2010.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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